Is the global risk-on rally over?
In the last few days, we have seen a sharp sell-off in the global equity markets, raising concerns on whether the global risk-on rally is over. In simple language, risk-on is a phase when investors in financial markets are willing to take more risk, and, hence, riskier assets like equity, emerging-market currencies and commodity prices experience a synchronized rise.
The current long-term rally in equity markets started in early 2016. An improving global business cycle, positive economic data releases and hopes about President Donald Trump’s stimulus and tax cuts for the US economy have been drivers of this rally. Between February 2016 and January 2018, the MSCI (Morgan Stanley Capital International) equity index for advanced economies went up 43%. Other asset classes joined this party more prominently in 2017.
If we look at the major turning points in financial markets, we find four prominent peaks in this century so far—March 2000 (before the bursting of the dot-com bubble), October 2007 (before the global financial crisis), April 2011 (the European sovereign debt crisis) and May 2015 (global growth concerns). Each of these points was preceded by rallying markets, ending with some or the other crisis.
The rallies that preceded the March 2000 and October 2007 peaks had run for several years and were followed by very sharp falls. Since the global financial crisis, rallies and falls have been comparatively shallower. Perhaps this reflects the support that came quickly from the central banks whenever markets appeared to be entering “risk-off” episodes. Richer valuations have been a feature of almost every rally. The 2000 peak had the richest valuations, when forward PE ratio (price-earnings) crossed 24 for the MSCI world index. When markets peaked in 2007, the PE ratio was around 15-16. The current PE valuation, at 16.7, for the MSCI world index is rich by historical standards.
The peaks of 2000, 2007 and 2011 in equity markets were accompanied by strong gains in the commodity markets. In the current rally, commodity markets have lagged behind when seen on a long-term chart—notwithstanding the gains seen in many commodities in 2017. This could be a reflection of structural factors, such as the rise of US shale oil and gradual cooling of Chinese commodity demand. Another difference in the recent equity rallies has been with regard to their relationship with the bond market. As per conventional wisdom, during a risk-on phase, bond yields increase as economic trends suggest higher growth and inflation. In this decade, however, yields were on a steady decline as central banks’ ultra-loose monetary policies boosted equity markets and bond markets at the same time. Long-term bond yields have moved up only recently.
Global growth is strong and gross domestic product (GDP) grew from 3.2% in 2016 to 3.7% in 2017, and is projected to further improve to 3.9% in 2018, as per the International Monetary Fund (IMF). This is the first time after nine years that IMF has upgraded the global GDP growth outlook. GDP growth has improved for most economies, including the US, Japan, China and also emerging economies like Indonesia and Thailand. Synchronized improvement in global growth are also getting reflected in higher global trade. Global merchandise trade volume jumped to 3.6% in 2017 from a lacklustre growth of 1.3% in 2016. The improving growth scenario has been coupled with an improvement in employment outlook. The US unemployment rate dropped to a 17-year low of 4.1% in December 2017.
Deflation was a concern for major economies like the US, European Union (EU) and Japan till a year back. But prices have risen since 2017, shrugging off fears of deflation in developed economies. Prices have been inching up in emerging economies also, bolstered by the rise in commodity prices. However, overall inflation remains within the comfort zone. This brings the global economy to a Goldilocks scenario of high growth and low but positive inflation.
The improving economic outlook has resulted in improved sentiment.Worldwide business optimism, according to the IHS Markit Global Business Outlook survey, climbed to a three-year high in October 2017. Consumer sentiment has also improved in most economies. US consumer confidence, as measured by the Conference Board, rose to a 17-year high in November-December 2017. China’s consumer confidence reached an all-time high in October 2017.
So, does the recent equity sell-off signal an end to the global risk-on rally? The recent sell-off was being predicted for quite a while by those who believe in mean-reversion theory (which suggests that extreme positions in any cyclical variable revert towards their long-term average). Many analysts monitoring equity valuations have been warning for a while that a correction is overdue.
However, we must not forget that the recent rally was being supported by the healthy state of the global economy and improving business cycle. Another important factor is that the central banks—in this case the US Fed—could come to the market’s rescue. The current sell-off has been triggered by the fear of the US Fed hiking rates at a faster pace than earlier anticipated. The Fed has learnt its lessons from the “taper tantrum” experience of 2013, when global financial markets fell dramatically on fears of the US hiking interest rates, threatening to destabilize the global economy. The US Fed is unlikely to take that kind of risk at this point of nascent global economic recovery.
Mangesh Soman, Rajani Sinha and Rutuja Morankar are Mumbai-based corporate economists.